Spending your funds wisely is one of the best pieces of tech startup advice that founders should follow. According to a study by U.S. Bank, 82 percent of small businesses that fail, do so because of cash flow management issues.
If you run through your money too quickly, you may be forced to close your doors before your next milestone and fundraising round. On the other hand, if you spend too little, your company may not grow aggressively enough to attract interest from future investors.
When it comes to startup investing and funding, there are two metrics that go hand-in-hand that founders need to keep in mind: startup runway and burn rate. In this article, we’ll discuss the definitions of startup runway and burn rate, why these metrics are so important, and how to calculate burn rate for startups.
How much runway should a startup have?
Startup runway (also known as a funding runway or investment runway) is defined as the amount of time that a startup has before it runs out of money. Before this date, the company will either need to secure other funding sources or become profitable and self-sustaining, or it will go out of business.
Founders must have at least a rough estimate of their startup runway in order to perform mission-critical tasks such as budgeting, forecasting, and strategizing. Calculating runway involves two figures: the amount of cash you have on hand and your company’s burn rate (the amount of money you spend each month, which we’ll discuss in the next section).
The amount of runway that a startup should have will depend on multiple factors: your industry, your current growth rate, and the stage of your business. Having too much in the bank could make investors feel that their services aren’t needed, while having too little could make them question why your funding efforts have been lackluster.
Traditionally, conventional wisdom has dictated that 12 to 18 months is a good startup runway target. Research by Florida International University, however, reveals that companies spend a median of 19 months between their Series B and Series C funding rounds, which suggests that these numbers may be an underestimate for later-stage startups.
Why does burn rate matter?
As mentioned above, a company’s burn rate is the amount of cash that it “burns through” each month. This metric is most important for startups and struggling businesses that are operating at a loss.
Since many startups have yet to achieve profitability, a company’s burn rate is a crucial concern for investors. If a company is spending too much, too fast, it could be a warning sign to investors that their own funds might go to waste. Conversely, a low burn rate could indicate that a company is growing too slowly to see a worthwhile return on investment.
Knowing your startup burn rate is also a prerequisite for calculating the length of your runway. For example, if a company has $1 million in the bank and a monthly burn rate of $100,000, then it has roughly 10 months to secure additional funding before it runs out of cash.
Thus, calculating your burn rate helps founders determine the best strategy for fundraising before their assets are spread too thin. So with that in mind, how do you calculate your startup’s burn rate?
How to calculate burn rate
Understanding how to calculate burn rate is an essential skill for tech startup founders. If you need some assistance, many websites have a burn rate calculator where you can plug in your financial numbers for a rough estimate.
Of course, calculating burn rate by hand will likely give you a better result than an automated startup burn rate calculator. The equation for computing your startup’s burn rate is simple:
- Select a time period over which to calculate the burn rate.
- Subtract the starting balance at the beginning of this time period from the ending balance at this period’s conclusion.
- Divide the result by the length of the time period in months.
For example, suppose that your startup currently has $800,000 in the bank, and you had a cash balance of $1 million 4 months ago. Doing the math, this means that you spent $200,000 over 4 months for a monthly burn rate of $50,000.
One important subtlety when calculating burn rate is to select the right time period. If the period is too short, outliers (i.e. months where you spent more or less than average) can have a large influence on the result. If the period is too long, it may not give an accurate picture of your most recent spending habits.
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